Foreign Portfolio Investment and the Financial Constraints of Small Firms (Management Project)

This project examines the impact of foreign portfolio investment on the financial constraints of small firms. Utilizing a dataset of over 195,000 firm-year observations across 53 countries, I examine the impact of foreign portfolio investment on capital issuance and firm growth across countries and firm characteristics, in particular size.

After controlling for firm, industry and country-level characteristics such as change in foreign exchange rate, share of market capitalization, relative interest rates and investment climate, I find that foreign portfolio investment helps to bridge the gap between the amounts of financing small firms require and that which they can access through the capital markets. Specifically, I find that foreign portfolio investment is associated with an increased ability to issue publicly traded securities for small firms in all nations, regardless of property rights development.

For those small firms that do issue, the form of capital appears to be debt. Since small firms often rely heavily on bank lending, I also test for potential increases in credit for small firms utilizing the bank lending theory of monetary transmission. Results show significantly decreased short-term debt and increased long-term debt, supporting the contention that bank debt maturity to these firms has increased. This transition to longer-term debt could also be as a result of the increased public debt securities these firms are more able to access.

The overall increased access to capital only leads to value-enhancing growth at the firm level in nations with more developed property rights. I find that the volatility of foreign portfolio investment is significantly negatively associated with the probability of small firms issuing publicly-traded securities as well as their firm growth, in periods when their domicile nations are deemed less ‘creditworthy.’ Results underscore the significance of a good financial system that minimizes information asymmetry and enhances liquidity, as well as property rights and country creditworthiness, to instill confidence in foreign investors.
Source: University of Maryland
Author: Knill, April Thompson